Beware! The Holy Grail

By Chad Karnes

Published May 27, 2014

ETFguide

One of the toughest jobs an investor has is finding indicators that work during all kinds of markets, not just bull markets.

Too often analysts find something that has signaled key market turning points and they jump on it as if it were a holy grail to analysis. The problem is that most times these indicators work well…until they don’t, turning paper profits to realized losses.

Analysts may use momentum indicators like moving averages, point and figure, fundamentals, or even more complicated versions that combine multiple data sources to make investment decisions. They look at recent history, see that their indicator would have been profitable, and then apply it going forward. Things may start off well, but eventually the future proves it is not the past, as such a technique necessitates, and all gains are wiped out.

Data Fitting

Take the lesser known NVI (Negative Volume) indicator, for example.

Developed in the 30s by Paul Dysart, the indicator seeks to put more value on lower volume days and no value on higher volume days. When the indicator rises it means the S&P rose on a day that volume was less than the previous day’s volume. If volume is increased, the day’s price change is discarded.

The theory behind the indicator is that contrary to popular belief large institutions are actually the more active market participants during days of low volume, thus giving more weight to those days, and the less important retail investor is the driver of volume on higher volume days.

The chart below shows the NVI’s recent history and indeed how a strategy of buying the market when the NVI crosses its moving average has captured the majority of the bull move (SNP:^GSPC) since 2009. Following the indicator as a trading signal, investors wouldn’t have sold out of any of the market’s pullbacks and be up around 67% so far on paper. Not bad!

Have we found our holy grail?

Law of Large Numbers

In statistics, the law of large numbers states that the more data one has in analysis, the more likely the realistic mean is to be like the theoretical mean. We discussed this in more detail with our subscribers recently in our Technical Forecast concerning the “Sell in May and Go Away” tactic and how it hasn’t been the best strategy over the past five years.

In the above chart, the analysis only includes one data point, the Buy signal in late 2009.

In more detailed statistical analysis, terms such as p-value, significance levels, and normal distribution utilize the law of large numbers to ultimately prove that the more data points a data set has, the more the results can be trusted.

The above chart again only has one data set, definitely not enough to be viable and pass any rudimentary statistical analysis.

It is almost always better to have more data rather than less data, and in market analysis this typically means more history.

The chart below shows what happens to this same strategy if history is expanded back to 1999.

The strategy was an absolute bust the 10 years prior to 2009’s buy signal. Including the positive performance since 2009, you would still be down significantly after 15 years, and that assumes you don’t give back most of your gains before the next sell signal.

Beware the use of one single indicator with few data points to make your investment decision as timing often proves much more important than strategy.

There is No Holy Grail, only Probabilities

We don’t pretend to have the holy grail or a crystal ball, but there are ways to tip the odds in your favor in the markets (PSQ).

One of these is to utilize more data and history when it is available to you, otherwise you may fall victim to recency bias or temporary market conditions.

One recent example how we were able to expand the data set and tilt the odds in our subscribers’s favor was regarding the precious metals.

Instead of focusing on 2013’s recent 30% decline in precious metals (NUGT) as many of the talking heads were, we took a step back and looked at the bigger picture as was stated in our January ETF Profit Strategy Newsletter when we saw a buy signal, “the smart money has been long gold on every single major bottom in gold and this could mean a sharp upward reversal in gold prices, at the very least.”

While everyone was bearish gold, we saw an opportunity that history helped support and suggested to our subs on 12/20 it was time to buy gold. We got out a few months later with a 60%+ gain on the suggested GLD (GLD) call options and a 10%+ gain on the Gold Miners (GDX) ETF suggested via our Weekly Pick a few days later.

Although certainly not a holy grail we were able to shift the odds in our favor by avoiding recency bias and being better stewards of history.

The ETF Profit Strategy Newsletter utilizes technical, sentiment, and statistical analysis to keep investors on the right side of the markets. When it comes to holy grails, there are none; recognizing this, you are already a step ahead in this game.